Owning Rentals in an S Corporation Might Be a Costly Mistake: Here’s Why

S Corporations can be a great entity to have if you are in the business of flipping properties, running a professional practice, or doing construction. They provide great asset protection and may help you minimize self-employment tax that you would normally have with an LLC. An S Corporation also helps you to avoid the double taxation that you may have with a C Corporation. However, if you own rental real estate, then you may want to consider forming a different entity.

Here’s why.

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The Issues with Transferring Appreciated Real Estate

Holding real estate in an S Corp does not pose a problem while it is held. You can collect rent, pay expenses, and put the property in the name of the S Corporation. Business is run as usual, and asset protection is in effect if you operate the corporation property.

The issues arise when it’s time to get the property out of the entity. Now, you might be thinking, “Why would I want to transfer property out of an S Corp?” There are many reasons why an investor may want to get properties out of an S Corporation. One of the most common ones we see is with respect to financing. Some banks will lend money to an S Corp, and other lenders will only allow you to finance or refinance if the title is in your personal name. Another common reason we see investors transfer title of a property from their S Corporation into their personal name is when they turn the rental into their primary home.

A Real Life Example

Last year a family friend of mine, Tracy, decided that she wanted to sell one of her rental properties. She had purchased the single family home for $150,000 several years ago, and the fair market value of the property was now close to $300,000. Tracy was excited to learn that her property appreciated so much, but she was dreading the capital gains taxes that she may have to pay.

After speaking with her tax advisor, Tracy learned that she could potentially exclude the gain on the sale of this property if she lived in the home for two of the five years prior to selling the home, so she decided that she would turn this property into her primary home. That way, she could potentially create more appreciation in the next few years with this property and possibly pay zero tax on the gain of this investment. This all sounded like a wonderful plan until she found out there was a catch to her brilliant idea.

The catch was that this investment property was currently held in her S Corporation. By transferring the property out of the S Corp, the IRS treats this transaction as a “sale.” In the eyes of the IRS, Tracy was essentially selling the property to herself for the property’s fair market value of $300,000, triggering a $150,000 gain that she would have to pay tax on that year. Can you imagine paying taxes on a $300,000 taxable gain when the property was not sold and title was merely transferred from your S Corporation to your personal name?

As you can see, this was a potentially huge problem for Tracy. She would need to be able to come up with the cash to pay taxes on this “sale” of the property when no actual sale had occurred. This is one of the pitfalls of having rental properties in an S Corporation that investors are often unaware of.

Also, keep in mind that if Tracy’s S Corp had other owners besides herself, then the other shareholders would not have been very happy with her when she transferred that property, as they would have also been required pay tax on that gain in proportion to their share of the S Corporation. If, for instance, there are five shareholders and each owned 20% of the corporation, then each of them would need to pay tax on $30,000 of the gain.

The small amount of good news is that in the future when it was time to really sell the home, Tracy’s basis in the property would be $300,000, not $150,000. If the house rose in value over the next few years, then she could exclude some of the additional gain when it came time to sell, but as far as excluding the $150,000 that year, Tracy’s strategy would fail miserably.

Whether you are moving a property out of an S Corporation for loan purposes or to turn it into your primary home, be sure to plan with your tax advisors strategically prior to making this move.

Transferring Depreciated Real Estate May Not be Beneficial Either

Although you can avoid paying tax by transferring property that has depreciated in value, there isn’t a benefit to doing this either. Most would think that if you recognize a gain when fair market value is higher than the purchase, then you would recognize a loss if the fair market value is lower. Generally, this is the case, but not when it comes to transferring property out of an S Corp. The loss essentially disappears, as the S Corp cannot recognize it. So even though you avoid paying tax, you also miss out on deductions.

Even if your property has gone down in value, you may still trigger a gain. The gain on the distribution is calculated by taking the fair market value minus your adjusted basis. Adjusted basis is your purchase price minus any depreciation you have taken on the property. So if you purchase a property for $100,000 and take $5,000 of depreciation each year for five years, then your adjusted basis is actually $75,000. If the fair market value falls to $90,000, even though it is lower than your purchase price, it is higher than your adjusted basis, and you may have to pay tax on a $15,000 gain. Again, please make sure to speak with your tax advisor before moving properties in or out of your legal entities.

Why LLCs May Be a Better Option

If Tracy had held her rental property in an LLC, then her gain exclusion strategy could have potentially worked. If she had transferred her $150,000 property out of an LLC, then there would have been no gain since it is not deemed as a sale. It’s simply treated as a distribution. She would have kept the $150,000 basis, and if she lived in the house for two years, then she have may potentially excluded the $150,000 gain when she sold the property.

Holding rentals in an LLC creates much more flexibility if you need to move rentals to a new LLC, convert one to a primary home, or transfer to your personal name to refinance. For example, if your business does both fix and flips and rentals, you may want to consider separating the two businesses. Hold your fix and flip properties in an S Corp, and keep your rentals in LLCs.

Before you go out to form that new entity, do make sure to speak with your tax advisor because there are always exceptions to the rule. Make sure that you have the best type of entity for your real estate business. Oh, and don’t forget to get your book today on Tax Saving Strategies for the Savvy Real Estate Investor. It just may be a tax deduction that can save you tons of money!

[Editor’s Note: We are republishing this article to help out our newer readers.]

Investors: Have any questions about legal entities and rental properties?

Leave your comments below!

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About Author

Amanda Han of Keystone CPA is a tax strategist who specializes in creating cutting-edge tax saving strategies for real estate investors. As real estate investors herself, Amanda has an in-depth understanding of the various aspects of investing including taxation, self-directed investing, entity structuring, and money-raising.

I’ve heard of a newbie badly advised by a CPA of all people to title his rental into an S corp,,, and then charged out the ying yang for corp returns AND personal, instead of just a 1040 with a sched E. Crying shame things like that happen.

Good this gets written up to educate new folks!

Nononse I go to Pete Fortunato’s yearly advanced tactics class (google able) his hot tip re engaging a PM is to do a master lease between the owner (you) and the S corp PM co. In most states this transfers 3rd party liability should it leak out of the titleing structure of the house if it’s bank owned and must be in ones name, to the LLC as S corp which has much better liability protection even if bank owned and in your name. A master lease is not a perfect nor infinite conduit of liability but it’s one help. Plus the PM org has “control” over the home in a master lease vs just a 10% management fee agreement.

Great article and I agree with all the points as a CPA myself who specializes in Real Estate taxation. Like Amanda I’m also an investor.

Another interesting spin-off of a traditional LLC is a series LLC. I’ve seen a lot more of those come through our office and see the benefits to them as well. Has anyone else heard of, or used a series LLC? I bought a property in IL several years back and utilized the series LLC but eventually dissolved it because it didn’t really generate the benefit I thought it would.

Thank you for your thoughts Michael. A series LLC does have some benefits, but as with everything there is no one strategy that fits all. Its always best to work with your advisor to understand what is going to make the most tax sense for your own situation.

I don’t understand why Tracy had to have a gain if she would purchase the same property for book value of 150K? This doesn’t make cense to me, why did she had to acquire it for 300k if she could do it for 150k, live in the property for 2 years, sell it and don’t pay capital gain tax for up to 250k (single) and 0.5M married

movement of the property from S corp to personal name is a “deemed sale” in the eyes of the IRS and the IRS requires distributions of assets to be at FMV and not cost basis. So the strategy is to get an outside appraisal or confirmation for the property’s lowest FMV at the time of title transfer.

What if, instead of just transferring the title, Tracy’s s-corp actually sold the property to Tracy for whatever price the s-corp wanted to sell it for, even much less than FMV if it wanted. Then the s-corp would make money, and would distribute that money to its shareholder, i.e. Tracy. She would of course have to pay income tax on that gain, but that would probably be less than having to pay tax on the difference between the original sale price minus depreciation and the new FMV. Or doesn’t that strategy work?

Amanada, just for fun let me give you my scenario. About 30 or more years ago my Sub S corp was formed. I bought into it about 20 or more years ago. I am not the only owner. I have it this way since the banks require every shareholder to personally guaranty loans. I know I should start a new LLC for new acquisitions but that means a new checking account, a new savings account for deposits, another set of annual minutes, another annual state filing, another tax return, etc.
My plan is after I quit buying to start giving my kids one or 2 shares of stock a year to keep under gifting guidelines and slowly divest myself of ownership and possibly sell some more stock to them. Is this reasonable?

I’ve heard that if you deed mortgaged properties to the s-corp, you can get them off of your name and the mortgage no longer counts against your 10 loan limit personally and if your spouse/partner can also qualify, their loan limit of 10 but if you deed mortgaged properties to an LLC that you and your partner share, a mortgage counts against you both jointly, lowering both your loan limits by 1 for 1 property only. Is this true?

Why anyone would own passive investments in an s-corp, or any corp is beyond me. Flipping, management, wholesale, etc income is for corps. Or selling books. Earned income.
Passive assets and passive income is for LLCs, if at all. Not everyone even needs one of those. Cheers!

If a property has been a rental for a few years and then becomes a personal residence, doesn’t the gain have to be prorated at the time of sale, based on the percent of time it was a rental? I think this started in 2009.What would be the best way to prevent future gains in the property value from being split.

Amanda, great article! This is great insight on the process of creating a smart business as you grow a rental portfolio. I have a company within an S-Corp, and have never thought about the disadvantages of putting rentals into another S-Corp. I’ll keep those within an LLC.

Is it possible to just quit-claim the properties out of your s-corp and into your personal name with no tax implications? I have done that in the past, I was wondering if you could advise on this.
Thanks

After speaking with her tax advisor, Tracy learned that she could potentially exclude the gain on the sale of this property if she lived in the home for two of the five years prior to selling the home, so she decided that she would turn this property into her primary home. That way, she could potentially create more appreciation in the next few years with this property and possibly pay zero tax on the gain of this investment. This all sounded like a wonderful plan until she found out there was a catch to her brilliant idea.”

This information from the “tax adviser” is likely erroneous regardless of the S Corporation transfer.

Per section 121, a person may be able to avoid paying taxes on the sale of their primary residence, but only during the time she lived in the property and if this person lived there 2 out of the last 5.

IRC Section 121(d)(6), stipulates that the capital gains exclusion shall not apply to any gains attributable to depreciation since May 6, 1997 (the date the rule was enacted), ensuring that the depreciation recapture will still be taxed (at a maximum rate of 25%).

IRC Section 121(b)(4), stipulate that the capital gains exclusion is specifically available only for periods during which the property was actually used as a primary residence; any other time (since January 1st, 2009)

Great article, Amanda! I would add that in some local markets, transferring a property from one entity to another, even if it is just between LLCs owned by the same member, will trigger a transfer tax on the accessed value. For example, here in Philadelphia this will cost the owner a total of 4% (2% in, 2% out) of the accessed value. That, along with the great points you made in this article, are examples of how advantageous it is for all investors to ensure the correct entities are being used from the start.

I’m a real estate broker and have mainly done wholesaling and traditional buyers with my brokerage. My question…If I want to start buying fix and flips, can I do so using my brokerage entity, or should I just purchase as myself?

What does the LLC protect most typical investors from? I think most investors reading this blog don’t need an LLC to put their property in. Normal owners of rental homes or duplexes or fourplexes are protected by their homeowners insurance policies and I am not aware of any owners protected more because they used an LLC. Can anyone reading this point me to some reasons to have an LLC backed up by some evidence? I have been confused by this for years.